Wall Street Outsiders Versus The Hedge Funds

hedge fund

The investment world was convulsed last week when at least one hedge fund (Melvin Capital) lost billions of dollars. The sudden, massive losses happened when a tidal wave of independent individual investors, spearheaded by posts on Reddit.com, triggered a short squeeze that torpedoed the hedge fund.

For those of you unfamiliar with a “short squeeze,” let me explain. Most stock market investors “go long”. That means that they buy a stock and then hope to sell it later at a higher price. Short sellers do the same thing except in reverse sequence—that is, they sell first, hopefully at a high price—and then buy later, hopefully at a lower price. Whereas “long” investors make money when the price rises, short-sellers make money when it falls.

A short squeeze happens when increased buying volume starts to push the price higher. Every dollar the price rises inflicts losses on short sellers. Because the only way to sell a stock short (that is, to sell a stock you don’t have) is to borrow it from a broker, the short seller not only pays interest on the borrowed shares but as the price rises, he is legally required to transfer more money in his brokerage account to make sure that the lender doesn’t end up eating the losses. These are the infamous “margin calls”. The more the stock rises, the larger the margin calls and, thus, the more the short sellers are “squeezed”. The only way to stop losing money is to exit the short position by buying back the stock. But guess what? Buying back the stock adds to the buying pressure, pushing the price of the stock up, even more, causing more short sellers to capitulate and buy back their shares. It’s a vicious cycle that can lead to a buying frenzy.

That is exactly what happened last week. The stock of a company called GameStop Corp. GME, which had been trading at under $20 per share for ages, rose to over $400 per share in just a couple of days when an unorganized gang of individual investors—the “Reddit mob”—bought lots of GameStop’s shares. This triggered a massive short squeeze that caught Melvin Capital off guard. Melvin’s strategists apparently had no exit plan in the case of the market turning against them, so they got roasted by the short squeeze, suffering massive losses.

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